Chapter 25.

Tool Kit for Real Options

THE INVESTMENT TIMING OPTION: AN ILLUSTRATION (Section 25.2)

Murphy Systems is considering a project that will create a new type of hand-held device for connecting to
the Internet. The cost of the project is $50 million, but the future cash flows are uncertain. Murphy
estimates a 25% probability that the new Internet device will be very popular in which case the project will
generate cash flows of $30 million each year for three years. There is a 50% probability generating cash
flows of $25 million each year for three years. Unfortunately, there is a 25% chance that the Internet device
will not be popular, which means that the project will generate only $5 million per year in cash flows. The
cost of capital for this project is 14%.

WACC= 14%
Risk-free rate = 6%
Initial cost of project= $50

DCF Analysis

Expected annual cash flows (in millions):

Probability Cash Flow Prob. x CF
25% $33 $8.25
50% $25 $12.50
25% $5 $1.25

Expected CF = $22.00

Time Line Year 0 1 2 3

Expected CF ($50) $22.00 $22.00 $22.00

NPV = $1.08

Figure 25-1 DCF and Decision Tree Analysis for the Investment Timing Option
(Millions of Dollars)

Part 1. Scenario Analysis: Proceed with Project Today

Future Cash Flows NPV of this
Now: Year 0 Year 1 Year 2 Year 3 Scenarioa Probability

0.25 $33 $33 $33 $26.61 0.25

High
-$50 Average
0.50 $25 $25 $25 $8.04 0.50
Low
0.25 $5 $5 $5 -$38.39 0.25
 1.00

Expected value of NPVs =

Standard Deviationb =

Coefficient of Variationc =

Part 2. Decision-Tree Analysis: Implement in One Year Only If Optimal

Future Cash Flows NPV of this
Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenariod Probability

0.25 -$50 $33 $33 $33 $23.35 0.25

High
0.50
Wait Average -$50 $25 $25 $25 $7.05 0.50
Low
0.25 $0 $0 $0 $0 $0.00 0.25
1.00

Expected value of NPVs =

Standard Deviationb =

Coefficient of Variationc =

Notes: a
The WACC is 14%.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.
d
The NPV in Part 2 is as of Year 0. Therefore, each of the project cash flows is discounted
back one more year than in Part 1.

Figure 25-2 Sensitivity Analysis for the Investment Timing Option Decision Tree
(Millions of Dollars)

Part 1. Decision-Tree Analysis: Implement in One Year Only If Optimal (Discount Cost at the
Risk-Free Rate and Operating Cash Flows at the WACC)

Future Cash Flows NPV of this

Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 -$50 $33 $33 $33 $20.04 0.25

High
0.50 -$50 $25 $25 $25 $3.74 0.50
Average
Low

0.25
$0 $0 $0 $0 $0.00 0.25
 0.25
1.00

Expected value of NPVs =

Standard Deviationb =

Coefficient of Variationc =

Part 2. Sensitivity Analysis of NPV to Changes in the Cost of Capital Used to

Discount Cost and Cash Flows

Cost of Capital Used to Discount the Year 1 Cost

$6.88 3.0% 4.0% 5.0% 6.0% 7.0% 8.0%
Year-4 Operating Cash Flows
Discount the Year-2 through

8.0% $13.11 $13.46 $13.80 $14.14 $14.47 $14.79

Cost of Capital Used to

9.0% $11.78 $12.13 $12.47 $12.81 $13.14 $13.47

10.0% $10.50 $10.85 $11.20 $11.53 $11.86 $12.19
11.0% $9.27 $9.62 $9.97 $10.30 $10.64 $10.96
12.0% $8.09 $8.44 $8.78 $9.12 $9.45 $9.78
13.0% $6.95 $7.30 $7.64 $7.98 $8.31 $8.64
14.0% $5.85 $6.20 $6.54 $6.88 $7.21 $7.54
15.0% $4.79 $5.14 $5.48 $5.82 $6.15 $6.48
16.0% $3.77 $4.12 $4.46 $4.80 $5.13 $5.45
17.0% $2.78 $3.13 $3.47 $3.81 $4.14 $4.46
18.0% $1.83 $2.18 $2.52 $2.86 $3.19 $3.51

Notes: a
The Year 2 through Year 4 operating cash flows in are discounted at the WACC of 14%. The
cost in Year 1 is discounted at the risk-free rate of 6%.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.

Real Option Analysis

The option to defer the project is like a call option. The company has until Year 1 to decide whether or not
to implement the project, so the time to maturity of the option is one year. If the company exercises the
option, it must pay a strike price equal to the cost of implementing the project. If the company does
implement the project, it gains the value of the project. If you exercise a call option, you will own a stock
that is worth whatever its price is. If the company implements the project, it will gain a project, whose value
is equal to the present value of its cash flows. Therefore, the present value of a project's future cash flows
is analogous to the current value of a stock. The rate of return on the project is equal to its cost of capital.
To find the value of a call option, we need the standard deviation of its rate of return; to find the value of this
real option, we need the standard deviation of the projects expected rate of return.

The first step is to find the value of the project's future cash flows, as of the time the option must be
exercised. We also need the standard deviation of the project's value as of the date it must be exercised.
Finally, we need the present value of the project's future cash flows.
Figure 25-3 Estimating the Input for "Stock Price" in the Option Analysis
of the Investment Timing Option (Millions of Dollars)

Future Cash Flows PV of this

Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 $33 $33 $33 $67.21 0.25

High
0.50
Average $25 $25 $25 $50.91 0.50
Low
0.25 $5 $5 $5 $10.18 0.25
1.00

Expected value of PVs =

Standard Deviationb =

Coefficient of Variationc =

Notes: a
The WACC is 14%. All cash flows in this scenario are discounted back to Year 0.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.

Figure 25-4 Estimating the Input for "Stock Return Variance" in the Option Analysis
of the Investment Timing Option (Millions of Dollars)

Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires

PV in Year 1
Future Cash Flows for this
Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 $33 $33 $33 $76.61 0.25

High
0.50
Average $25 $25 $25 $58.04 0.50
Low
0.25 $5 $5 $5 $11.61 0.25
1.00

Expected value of PVYear 1 =

Standard Deviation of PVYear 1b =

 Coefficient of Variation of PVYear 1c =

Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return

Probability
PriceYear 0d PVYear 1e ReturnYear 1f Probability x Ret.Year 1

0.25 $76.61 71.0% 0.25 17.8%

High
0.50
$44.80 Average $58.04 29.5% 0.50 14.8%
Low
0.25 $11.61 -74.1% 0.25 -18.5%
1.00

Expected return = 14.0%

Standard deviation of returnb = 53.6%

Variance of returng = 28.7%

Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return

Expected "price" at the time the option expiresh = $51.08

Std. dev. of expected "price" at the time the option expiresi = $24.02
Coefficient of variation (CV) = 0.47
Time (in years) until the option expires (t) = 1.00

Variance of the project's expected return = ln(CV2+1)/t = 20.0%

Notes: a
The WACC is 14%. The Year 2 through Year 4 cash flows are discounted back to Year 1.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.
d
The Year 0 price is the expected PV from Figure 25-3.
e
The Year 1 PVs are from Part 1.
f
The returns for each scenario are calculated as (PVYear 1 - PriceYear 0)/PriceYear 0.
g
The variance of return is the standard deviation squared.
h
The expected "price" at the time the option expires is taken from Part 1.
i
The standard deviation of expected "price" at the time the option expires is taken from Part 1.

Figure 25-5 Estimating the Value of the of the Investment Timing Option Using
a Standard Financial Option (Millions of Dollars)

Part 1. Find the Value of a Call Option Using the Black-Scholes Model
 Real Option
rRF = Risk-free interest rate = 6%
t= Time until the option expires = 1
X= Cost to implement the project = $50.00
P= Current value of the project = $44.80
s2 = Variance of the project's rate of return = 20.0%

d1 = { ln (P/X) + [rRF + (s2 /2) ] t } / (s t1/2 ) = 0.112

d2 = d1 - s (t 1 / 2) = -0.33
N(d1) = = 0.54
N(d2) = = 0.37

V = P[ N (d1) ] - Xe-rRF t [ N (d2) ] = $7.04

Part 2. Sensitivity Analysis of Option Value to Changes in Variance

Variance Option Value

$7.04
12.0% $5.24
14.0% $5.74
16.0% $6.20
18.0% $6.63
20.0% $7.04
22.0% $7.42
24.0% $7.79
26.0% $8.15
28.0% $8.49
30.0% $8.81
32.0% $9.13

Notes: a
The current value of the project is taken from Figure 25-3.
b
The variance of the project's rate of return is taken from Part 3 of Figure 25-4.

THE GROWTH OPTION: AN ILLUSTRATION (Section 25.3)

Kidco Corporation designs and produces products aimed at the pre-teen market. Most of these products
have a very short life cycle, given the rapidly changing tastes of pre-teens. Kidco is considering one such
project, which will cost $30 million to implement and will last only two years. Kidco believes there is a 25
percent chance that the project will catch the fancy of pre-teens. In this scenario, it will generate cash flows
of $34 million in each of the next two years, after which pre-teen tastes are likely to change. There is a 50
percent chance of average demand for the new product, which produces expected cash flows of $19 million
annually for two years. There is a 25% chance that the pre-teens won’t like the product, and it will generate
cash flows of only $3 million per year. The cost of capital for this project is 14%.

WACC= 14%
Risk-free rate= 6%
Initial cost= $30

DCF Analysis

Expected annual cash flows (in millions):

Probability Cash Flow Prob. x CF
25% $34 $8.50
50% $20 $10.00
25% $2 $0.50

Expected CF = $19.00

Time Line Year 0 1 2

Expected CF ($30) $19.00 $19.00

NPV = $1.29

Figure 25-6 Scenario Analysis and Decision Tree Analysis for the Kidco Project
(Millions of Dollars)

Part 1. Scenario Analysis of Kidco's First-Generation Project

Future Cash Flows NPV of this

Now: Year 0 Year 1 Year 2 Scenarioa Probability

0.25 $34 $34 $25.99 0.25

High
0.50
-$30 Average $20 $20 $2.93 0.50
Low
0.25 $2 $2 -$26.71 0.25
1.00

Expected Value of NPVs =

Standard Deviationa =

Coefficient of Variationb =

Part 2. Decision-Tree Analysis of the Growth Option

Future Cash Flows NPV of this

Now: Year 0 Year 1 Year 2d Year 3 Year 4 Scenarioe Probability

0.25 $34 $34 $34 $34 $42.37 0.25

High -$30

0.50
 0.50
-$30 Average $20 $20 $20 $20 $1.57 0.50
-$30
Low

0.25 $2 $2 $0 $0 -$26.71 0.25

1.00

Expected Value of NPVs =

Standard Deviationb =

Coefficient of Variationc =

Notes: a
The operating cash flows are discounted by the WACC of 14%.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.
d
The total cash flows in Year 2 are equal to the operating cash flows for the first
generation product minus the $30 million cost to implement the second generation
product, if it is optimal to do so.
e
The operating cash flows in Year 1 through Year 4, which do not include the $30
million cost of implementing the second generation project in Year 2 for the high
demand and average demand scenarios, are discounted at the WACC of 14%. The
implementation cost in Year 2 for the high demand and average demand scenarios
is discounted at the risk-free rate of 6%.

Table 25-1 Sensitivity Analysis of the Kidco Decision Tree Analysis in Figure 13-6
(Millions of Dollars)

Cost of Capital Used to Discount the $30 Million Implementation

Cost in Year 2 of the Second-Generation Project
$4.70 3.0% 4.0% 5.0% 6.0% 7.0% 8.0%
8.0% $10.96 $11.36 $11.76 $12.14 $12.51 $12.88
Discount the Year-1 through

9.0% $9.61 $10.01 $10.41 $10.79 $11.16 $11.52

Cost of Capital Used to

Year-4 Operating Cash

10.0% $8.30 $8.71 $9.10 $9.49 $9.86 $10.22

11.0% $7.04 $7.45 $7.84 $8.23 $8.60 $8.96
12.0% $5.83 $6.23 $6.63 $7.01 $7.38 $7.75
Flowsa

13.0% $4.65 $5.06 $5.45 $5.84 $6.21 $6.57

14.0% $3.52 $3.92 $4.32 $4.70 $5.07 $5.44
15.0% $2.42 $2.83 $3.22 $3.61 $3.98 $4.34
16.0% $1.36 $1.77 $2.16 $2.54 $2.92 $3.28
17.0% $0.33 $0.74 $1.13 $1.52 $1.89 $2.25
18.0% -$0.66 -$0.25 $0.14 $0.52 $0.90 $1.26

Note: aThe operating cash flows do not include the $30 million implemetation cost of the second
generation project in Year 2.
Figure 25-7 Estimating the Input for "Stock Price" in the Growth Option Analysis
of the Investment Timing Option (Millions of Dollars)

Future Cash Flows PV of this

Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 $34 $34 $43.08 0.25

High
0.50
Average $20 $20 $25.34 0.50
Low
0.25 $2 $2 $2.53 0.25
1.00

Expected value of PVs =

Standard Deviationb =

Coefficient of Variationc =

Notes: a
The WACC is 14%. All cash flows in this scenario are discounted back to Year 0.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.

Figure 25-8 Estimating the Input for "Stock Return Variance" in the
Growth Option Analysis (Millions of Dollars)

Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires

PV in Year 2
Future Cash Flows for this
Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 $34 $34 $55.99 0.25

High
0.50
Average $20 $20 $32.93 0.50
Low
0.25 $2 $2 $3.29 0.25
1.00

Expected value of PVYear 2 =

Standard Deviation of PVYear 2b =

Coefficient of Variation of PVYear 2c =

Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return

Probability
PriceYear 0d PVYear 2e ReturnYear 2f Probability x Ret.Year 2

0.25 $55.99 52.5% 0.25 13.1%

High
0.50
$24.07 Average $32.93 17.0% 0.50 8.5%
Low
0.25 $3.29 -63.0% 0.25 -15.8%
1.00

Expected returng = 5.9%

Standard deviation of returnb = 42.3%

Variance of returnh = 17.9%

Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return

Expected "price" at the time the option expiresi = $31.29

Std. dev. of expected "price" at the time the option expiresj = $18.70
Coefficient of variation (CV) = 0.60
Time (in years) until the option expires (t) = 2

Variance of the project's expected return = ln(CV2+1)/t = 15.3%

Notes: a
The WACC is 14%. The Year 3 through Year 4 cash flows are discounted back to Year 2.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.
d
The Year 0 price is the expected PV from Figure 25-7.
e
The Year 2 PVs are from Part 1.
f
The annualized returns for each scenario are calculated as (PVYear 2/ PriceYear 0)0.5 - 1.
g
The expected annualized return is not equal to the cost of capital, 14%. However, if you do the
calculations then you’ll see that the expected 2-year return is 29.26%, which is equal to the 2-
year compounded cost of capital: (1.14)2 − 1 = 29.26%.
h
The variance of return is the standard deviation squared.
i
The expected "price" at the time the option expires is taken from Part 1.
j
The standard deviation of expected "price" at the time the option expires is taken from Part 1.

Figure 25-9 Estimating the Value of the of the Growth Option Using
a Standard Financial Option (Millions of Dollars)

Part 1. Find the Value of a Call Option Using the Black-Scholes Model
 Real Option
rRF = Risk-free interest rate = 6%
t= Time until the option expires = 2
X= Cost to implement the project = $30.00
P= Current value of the project = $24.07
s2 = Variance of the project's rate of return = 15.3%

d1 = { ln (P/X) + [rRF + (s2 /2) ] t } / (s t1/2 ) = 0.096

d2 = d1 - s (t 1 / 2) = -0.46
N(d1 )= = 0.54
N(d2) = = 0.32

V = P[ N (d1) ] - Xe-rRF t [ N (d2) ] = $4.34

Part 2. Sensitivity Analysis of Option Value to Changes in Variance

Variance Option Value

$4.34
11.3% $3.60
13.3% $3.98
15.3% $4.34
17.3% $4.68
19.3% $4.99
21.3% $5.29
23.3% $5.57
25.3% $5.84
27.3% $6.10
29.3% $6.35
31.3% $6.59

Notes: a
The current value of the project is taken from Figure 25-7.
b
The variance of the project's rate of return is taken from Part 3 of Figure 25-8.

Total project value = NPV of first generation project + Value of growth option
Total project value = $1.29 + $4.34
Total project value = $5.63
 9/22/2011

vice for connecting to

rtain. Murphy
h case the project will
lity generating cash
hat the Internet device
ar in cash flows. The

Probability Data for

x NPV Std Deviation

$6.65 163

$4.02 24

-$9.60 389
 577 =Variance of PV
$1.08

$24.02

22.32

Probability Data for

x NPV Std Deviation

$5.84 49

$3.53 3

$0.00 22

73 =Variance of PV
$9.36

$8.57

0.92

pected value.
ows is discounted

ision Tree

t at the

Probability Data for

x NPV Std Deviation

$5.01 43

$1.87 5

$0.00 12
 60 =Variance of PV
$6.88

$7.75

1.13

1 Cost
9.0%
$15.11
$13.78
$12.51
$11.28
$10.09
$8.95
$7.85
$6.79
$5.77
$4.78
$3.83

e WACC of 14%. The

pected value.

decide whether or not

pany exercises the
company does
you will own a stock
a project, whose value
ect's future cash flows
l to its cost of capital.
to find the value of this

option must be
t must be exercised.
 Probability Data for
x PV Std Deviation

$16.80 125

$25.46 19

$2.55 300

444 =Variance of PV
$44.80

$21.07

0.47

pected value.

ption Analysis

Probability Data for

x PVYear 1 Std Deviation

$19.15 163

$29.02 24

$2.90 389

577 =Variance of PV
$51.08

$24.02
 0.47

ect's Return

Data for
Std Deviation

8.1%

1.2%

19.4%

28.7% =Variance of PV

Project's Return

ed back to Year 1.

pected value.

s is taken from Part 1.

on Using
 a

ost of these products

considering one such
believes there is a 25
will generate cash flows
hange. There is a 50
ash flows of $19 million
uct, and it will generate
co Project

Probability Data for

x NPV Std Deviation

$6.50 153

$1.47 1

-$6.68 196

$1.29 350 =Variance of NPV

$18.70

14.54

Probability Data for

x NPV Std Deviation

$10.59 355
 $0.79 5

-$6.68 247

$4.70 606 =Variance of NPV

$24.62

5.24

pected value.

n Figure 13-6

mplementation
Project
9.0%
$13.23
$11.88
$10.57
$9.31
$8.10
$6.92
$5.79
$4.69
$3.63
$2.60
$1.61

ost of the second

on Analysis

Probability Data for

x PV Std Deviation

$10.77 90

$12.67 1

$0.63 116

207 =Variance of PV
$24.07

$14.39

0.60

pected value.

Probability Data for

x PVYear 2 Std Deviation

$14.00 153

$16.47 1

$0.82 196

350 =Variance of PV
$31.29

$18.70

0.60
 ect's Return

Data for
Std Deviation

5.4% High

0.6% Average

11.9% Low

Expected:
17.9% =Variance of PV

Project's Return

ed back to Year 2.

pected value.

However, if you do the

ich is equal to the 2-

s is taken from Part 1.

a

b
Unannualized 2-year return

133%

37%

-86%

29.96%
 Web 25A: THE ABANDONMENT OPTION

Intial Cost= $26

WACC= 12%
Risk free rate = 6%
After-tax salvage value = $14

DCF Analysis

Table 25A-1 Expected Operating Cash Flows for Project at Synapse Systems
(Millions of Dollars)
Operating Cash Flow
Demand Probability 2007 2008 2009 2010
High 25% $18 $23 $28 $33
Average 50% $7 $8 $9 $10
Low 25% -$8 -$9 -$10 -$12

Expected operating cash flow = $6.00 $7.50 $9.00 $10.25

Time Line Year Now: Year 0 Year 1 Year 2 Year 3 Year 4

Expected CF ($26) $6.00 $7.50 $9.00 $10.25

NPV = -1.74

Figure 25A-1 Scenario Analysis and Decision Tree Analysis for the Synapse Project
(Millions of Dollars)

Part 1. Scenario Analysis of the Project (Ignoring the Option to Abandon)

Future Cash Flows NPV of this Probability

Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 $18 $23 $28 $33 $49.31 0.25

High
0.50
-$26 Average $7 $8 $9 $10 -$0.61 0.50
Low

0.25 -$8 -$9 -$10 -$12 -$55.06 0.25

1.00

Expected Value of NPVs =

Standard Deviationb =
 Coefficient of Variationc =

Part 2. Decision-Tree Analysis of the Abandonment Option

Future Cash Flows NPV of this Probability

Now: Year 0 Year 1 d
Year 2e Year 3e Year 4 e
Scenariof Probability

0.25 $18 $23 $28 $33 $49.31 0.25

High
0.50
-$26 Average $7 $8 $9 $10 -$0.61 0.50
Low
0.25 $6 $0 $0 $0 -$19.94 0.25
1.00

Expected Value of NPVs =

Standard Deviationb =

Coefficient of Variationc =

Notes: a
The operating cash flows are discounted by the WACC of 12%.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.
d
The cash flow in Year 1 for the low demand scenario is equal to the -$8 million
operating cash flow plus the after-tax salvage value of $14 million, since Synapse will
abandon
e
The cashtheflows
proejct in this2scenario.
in Years though Year 4 for the low demand scenario are zero,
because Synapse abandons the project immediately after the -$8 million operating loss
in Year 1.
f
The operating cash flows in Year 1 though Year 4, which do not include the $14 million after-tax
salvage value, are discounted at the WACC of 12%. The $14 million salvage value in the low
demand scenario in Year 1 is discounted at the risk-free rate of 6%.

Figure 25A-2 Sensitivity Analysis of the Synapse Decision Tree Analysis in Figure 13A-1
(Millions of Dollars)
not include the $14 million after-tax salvage value
through Year-4 Operating Cash Flows (These do

Cost of Capital Used to Discount the $14 Million After-tax Salvage Value in the Low
Cost of Capital Used to Discount the Year-1

Demand Scenario of Year 1.

$7.04 3.0% 4.0% 5.0% 6.0% 7.0% 8.0%
8.0% $10.18 $10.15 $10.12 $10.08 $10.05 $10.02
9.0% $9.38 $9.34 $9.31 $9.28 $9.25 $9.22
10.0% $8.60 $8.57 $8.54 $8.50 $8.47 $8.44
in Year 1.)

11.0% $7.85 $7.82 $7.79 $7.76 $7.73 $7.70

12.0% $7.13 $7.10 $7.07 $7.04 $7.01 $6.98
13.0% $6.44 $6.41 $6.38 $6.34 $6.31 $6.28
14.0% $5.77 $5.74 $5.71 $5.67 $5.64 $5.61
 Cost of Capital Used to Dis

in Year 1.)
not include the $14 million aft
through Year-4 Operating Ca 15.0% $5.13 $5.09 $5.06 $5.03 $5.00 $4.97
16.0% $4.50 $4.47 $4.44 $4.41 $4.37 $4.34
17.0% $3.90 $3.87 $3.84 $3.80 $3.77 $3.74
18.0% $3.32 $3.29 $3.25 $3.22 $3.19 $3.16

Real Option Analysis Where Firm Has the Option to Abandon

Break the project into two projects plus an option to abandon the second project. Project A starts at time zero
and lasts one year. It has the initial cost and first-year operating cash flows of the original project. Project B
begins at Year 2 and last through Year 4. It has no initial cost, but has the Year 2 through 4 operating cash
flows of the original project. There is also a real option that allows you to abandon Project B if the value of B
at time 1 is less than the abandonment amount.

Figure 25A-3 Breaking Synapse's Project into Two Separate Projects

of the Investment Timing Option (Millions of Dollars)

Part 1. DCF Analysis of Project A that Lasts One Year

Future Cash Flows NPV of this Probability
Now: Year 0 Year 1 Scenarioa Probability

0.25 $18 -$9.93 0.25

High
0.50
-$26 Average $7 -$19.75 0.50
Low
0.25 -$8 -$33.14 0.25
1.00

Expected value of PVs =

Standard Deviationa =

Coefficient of Variationb =

Part 2. DCF Analysis of Project B that Starts at Year 1 If Project A is Already in Place
Future Cash Flows NPV of this Probability
Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenarioa Probability

0.25 $23 $28 $33 $59.24 0.25

High
0.50
Average $8 $9 $10 $19.14 0.50
Low

0.25 -$9 -$10 -$12 -$21.92 0.25

1.00

Expected value of PVs =

 Standard Deviationb =

Coefficient of Variationc =

Notes: a
The WACC is 12%. All cash flows in this scenario are discounted back to Year 0.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.

Figure 25A-4 Estimating the Input for "Stock Return Variance" in the
Abandonment Option Analysis (Millions of Dollars)

Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires

PV in Year 1
Future Cash Flows for this Probability
Now: Year 0 Year 1 Year 2 Year 3 Year 4 Scenario c
Probability

0.25 $23 $28 $33 $66.35 0.25

High
0.50
Average $8 $9 $10 $21.44 0.50
Low
0.25 -$9 -$10 -$12 -$24.55 0.25
1.00

Expected value of PVYear 1 =

Standard Deviation of PVYear 1b =

Coefficient of Variation of PVYear 1c =

Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return

Probability
Price Year 0
d
PV Year 1
e
Return Year 1
f
Probability x ReturnYear 1

0.25 $66.35 251.1% 0.25 62.8%

High
0.50
$18.90 Average $21.44 13.4% 0.50 6.7%
Low

0.25 -$24.55 -229.9% 0.25 -57.5%

1.00

Expected return = 12.0%

 Standard deviation of returnb = 170.0%

Variance of returng = 289.2%

Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return

Expected "price" at the time the option expiresh = $21.17

Std. dev. of expected "price" at the time the option expiresi = $32.14
Coefficient of variation (CV) = 1.52
Time (in years) until the option expires (t) = 1

Variance of the project's expected return = ln(CV2+1)/t = 119.5%

Notes: a
The WACC is 12%. The Year 2 through Year 4 cash flows are discounted back to Year 1.
b
The standard deviation is calculated as in Chapter 6.
c
The coefficient of variation is the standard deviation divided by the expected value.
d
The Year 0 price is the expected NPV from Part 2 of Figure 13-12.
e The Year 1 PVs are from Part 1.
f
The returns for each scenario are calculated as (PVYear 1/ PriceYear 0) - 1.
g
The variance of return is the standard deviation squared.
h
The expected "price" at the time the option expires is taken from Part 1.
i
The standard deviation of expected "price" at the time the option expires is taken from Part 1.

Figure 25A-5 Estimating the Value of the of the Abandonment Option Using
a Standard Financial Option (Millions of Dollars)

Part 1. Find the Value of a Put Option Using the Black-Scholes Model

Real Option
rRF = Risk-free interest rate = 6%
t= Time until the option expires = 1
X= Salvage value if abandon = $14.00
P= Current value of the Project B = $18.90 a
s2 = Variance of Project B's rate of return = 175.0% b

d1 = { ln (P/X) + [rRF + (s2 /2) ] t } / (s t1/2 ) = 0.934

d2 = d1 - s (t 1 / 2) = -0.39
N(d1) = 0.82
N(d2) = 0.35

V of Call = P[ N (d1) ] - Xe-rRF t [ N (d2) ] = $10.99

V of Put = Call - P + X e-rRF t

V of Put = $10.99 - $18.90 + $13.18
 V of Put = $5.28

Part 2. Sensitivity Analysis of Put Option Value to Changes in Variance

Variance Option Value

$5.28
55.0% $2.29
75.0% $2.94
95.0% $3.51
### $4.02
### $4.48
### $4.89
### $5.28
### $5.63
### $5.96
### $6.27
### $6.56

Notes: a
The current value of the project is taken from Figure 25A-3.
b
The variance of the project’s rate of return is chosen to be a value between the variances from
Parts 2 and 3 of Figure 25A-3.

Total NPV= NPV of A + NPV of B + Value of abandonment option

Total NPV= -$20.64 + $18.90 + $5.28
Total NPV= $3.53
 9/22/2011

pse Project

Probability Data for

x NPV Std Deviation

$12.33 652

-$0.31 1

### 711

-$1.74 1,363 =Variance of NPV

$36.92
 -21.17

Probability Data for

x NPV Std Deviation

$12.33 447

-$0.31 29

-$4.98 182

$7.04 658 =Variance of NPV

$25.65

3.64

$14 million after-tax

value in the low

in Figure 13A-1

age Value in the Low

9.0%
$9.99
$9.19
$8.41
$7.67
$6.95
$6.25
$5.58
 $4.94
$4.31
$3.71
$3.13

A starts at time zero

l project. Project B
4 operating cash
ct B if the value of B

Probability Data for

x NPV Std Deviation

-$2.48 29

-$9.88 0

-$8.29 39

68 =Variance of PV
###

$8.26

(0.40)

Probability Data for

x NPV Std Deviation

$14.81 407

$9.57 0

-$5.48 417

823 =Variance of PV
$18.90
 $28.69

1.52

Probability Data for

x PVYear 1 Std Deviation

$16.59 510

$10.72 0

-$6.14 522

1,033 =Variance of PV
$21.17

$32.14

1.518

Data for
Std Deviation

142.9%

0.0%

146.3%

289.2% =Variance of PV
ack to Year 1.

taken from Part 1.

the variances from

onment option